Turkey’s Economy minister must stop Ankara from backsliding into politics as usual if the country is ever to join the EU--or enjoy real prosperity.

Turkey’s Economy minister must stop Ankara from backsliding into politics as usual if the country is ever to join the EU--or enjoy real prosperity.

By Craig Mellow
February 2003
Institutional Investor Magazine

Turkey’s new, moderate Islamist government has vowed to whip inflation, put the country on an irrevocable path to membership in the European Union and root out corruption. But three months since the Justice and Development Party (AKP) took power, word of its plans evidently still has not reached the crowds inside the Parliament complex in Ankara.

The long hallways of Atatürk’s featureless brown low-rise buildings hum with a throng more reminiscent of the old ways of Istanbul’s Grand Bazaar than the quiet corridors of the House of Commons or the Reichstag. Most in the jostling crowds are looking for a handout.

“About 15,000 people a day come to Parliament for jobs or money for their villages. This shows that the system of public administration is not working,” says Yakup Kepenek, parliamentary deputy from the opposition, center-right Republican People’s Party (CHP) and a professor of economics at Ankara’s Middle East Technical University. “So far they are not getting anything from the new government, but they still come and hope.”

The formidable task of keeping Turkey’s public purse shut to favor-seekers great and small has fallen to Ali Babacan, a 35-year-old Northwestern University MBA and former Fulbright scholar, who was named Economy minister shortly after the AKP’s victory. It is precisely the AKP government’s independence from interest groups that distinguishes it from its doomed predecessors, says Babacan (pronounced Bah-bah-JON).

The AKP, under founder Recep Tayyip Erdo(breve)gan, is the first Turkish party since the 1980s to govern without coalition partners. That gives it five unchallenged years to take harsh, International Monetary Fundprescribed economic medicine and turn debt-ridden Turkey into a prosperous adherent of the EU’s Maastricht criteria, asserts Babacan during an interview with Institutional Investor (see box).

“This is a government that doesn’t owe anything to anybody,” Babacan declares. “That is an enormous chance for us.”

Financial markets bought into Babacan’s brave new words right after the November 3 election, cutting interest rates on Turkey’s debt from 70 percent to 50 percent within days of the AKP’s stunning victory and bidding up shares on the Istanbul Stock Exchange by 20 percent. But the party’s first three months in power have raised doubts about whether Babacan and other pro-IMF technocrats are really wielding the power under Erdo(breve)gan’s big political tent. The AKP has retreated from budget targets, raised pensions, scrapped a law to wring taxes from the self-employed and indicated that it plans to temper a measure to impose transparency on the awarding of public contracts.

A U.S.-led war with Turkey’s neighbor Iraq also looked increasingly likely in late January. The first Gulf War, in 1991, cost Turkey 5 percent of its GNP, or more than $5 billion, Babacan says -- a sum it could ill afford to forfeit now. Ankara is wheedling aid from Washington while simultaneously touring its Islamic neighbors to offer its services as a peacemaker. In the meantime, Turkish interest rates have climbed back to about 60 percent, and the stock market has relinquished its postelection gains.

The next three months will show more clearly whether the AKP, and its potentially world-altering promise of democracy with an Islamic face, is just having teething pains or stumbling like so many previous Turkish governments. Erdo(breve)gan’s loyalists must pass a budget, hold wage talks with more than 400,000 public sector workers and put enough flesh on their bare-bones plans for tax reform and privatization to reach a new IMF agreement -- all while coming to grips with Iraq.

“We still believe this government has the potential to transform Turkey,” says Mehmet Simsek, an emerging-markets economist with Merrill Lynch in London. “But so far they appear economically to be going for a populist quick fix. It’s not clear yet whether that’s fundamentally their approach or part of a political balancing act.”

The hordes besieging Parliament are a humble manifestation of the biggest problem confronting Turkey and Babacan today: debt resulting from an anarchic, decades-old system of public funds disbursed by politicians trying to build fiefdoms before their tenuous coalition governments collapsed. Turkey ran up $140 billion in debt over the past two decades and, by common consensus, wasted most of the proceeds. Public payrolls swelled to more than 3 million of the country’s 67 million people. State banks lent tens of billions that were never repaid. The Treasury funded grandiose but useless infrastructure projects like Sabiha Gökçen airport, which sits empty outside Istanbul.

The borrowing saddled Turkey with rampant inflation and a currency worth 1.7 million to the dollar in late January. The urge of competing factions to spend on their cronies sank the country to a 3.2 rating (out of 10) on Transparency International’s 2002 corruption-perceptions index, tied for 64th place out of 102 countries. In February 2001 a spat between thenprime minister Bülent Ecevit and President Ahmet Sezer over police powers provoked a flight from the lira, which spawned a financial crisis as banks dug into capital to repay hard-currency loans. Within a year the lira’s value fell by half, the Turkish economy shrank by a tenth, and the ancient trading power was left dependent on a $16 billion IMF program to stave off bankruptcy.

But that’s all in the past now, declares Babacan, who less than three years ago was helping his father run the family textiles business in Ankara. He found the fledgling AKP’s message of traditional values mixed with economic liberalism and respect for nonbelievers compelling. In 2001 he abandoned the family business to became economic coordinator for the party, which exIstanbul mayor Erdo(breve)gan formed from the ashes of Islamic parties banned by the military. During the 2002 campaign Babacan led a road show to Western financial capitals, promising to blend Islam with sufficient financial stringency to be the IMF’s star pupil.

On November 3 the AKP swept nearly two thirds of Turkey’s parliamentary seats (albeit with just 34 percent of the vote). The campaign cost a mere $6 million, all raised from state funds and members’ dues.

After the victory Babacan joined Erdo(breve)gan on a whirlwind tour of Europe to try to persuade EU heads of state to set a date for starting Turkey’s accession talks. The EU told Turkey to come back in late 2004, placing it behind Romania and Bulgaria in a long queue. But being in line at all is enough encouragement to keep Turkish reform on track, Babacan contends. “For at least the past 40 years or so, the idea of joining a European Union was always a virtual thing for Turkey. But right now it’s real,” he says. “The EU is a guarantee that Turkey is not going to take any backward steps.”

For forward steps, Babacan leans heavily on the program shaped by the IMF and his predecessor, Kemal Dervi¸s, in 2001. Dervi¸s, who is now an opposition legislator with the CHP, gave Babacan a good head start on financial stability, wrestling inflation down from 60 percent to 35 percent in 2002. It is still falling, sugaring the pill of austerity that Babacan -- who promises a 20 percent rate by the end of this year -- wants to keep administering.

“Inflation is currently around 29 percent. That’s something people are going to notice,” says Aydin Haskebapçi, financial editor at daily newspaper Zaman.

The AKP, says Babacan, will run a “substantial” primary budget surplus to squeeze debt, interest on which currently absorbs two thirds of central government spending. After the election he endorsed the IMF surplus target of 6.5 percent of GDP; now he declines to be pinned down. But he’s happy to tick off the other key parts of his agenda: The AKP will back the Turkish central bank, independent of the government since 2000, in fixing price stability as its lodestar. State enterprises from Türk Telekomünikasyon to alcohol-and-tobacco monopoly Tekel will be sold to private investors. Babacan himself will dismantle a bureaucracy that can require more than 100 official signatures for a single foreign investment. But there’s one IMF stipulation that he neglects to mention -- that as many as 30,000 workers be axed from state enterprises by the middle of this year.

Babacan will face plenty of opposition. For starters, there’s Türk-Is, Turkey’s biggest trade union, with about 900,000 members. Yildirim Koc, adviser to the union president, vows that no budgets will be balanced on the back of state employees. “If the government tries to implement the policies dictated by transnational capital, as represented by the IMF, we will revert to the kind of confrontation that brought down three Turkish governments in the 1990s,” Koc asserts. General strikes toppled two coalitions in 1995, he says, and workers’ protests helped sink a third in 1997.

Set amid kebab stands and the manual typewriters of street-corner scribes, Türk-Is’s headquarters is a long way from the glass-towered offices of the Ankara Chamber of Commerce, but Babacan doesn’t get much more support from small business than he does from labor. “Tight budgets will have a negative effect on the Turkish economy, which cannot grow if there is no investment,” says Chamber president Sinan Aygün, who says he speaks for 125,000 businesspeople across Anatolia.

“There’s low inflation in the Congo, Papua New Guinea and Afghanistan. What Turkey needs is development,” the business lobbyist continues. “The IMF almost destroyed Argentina. Turkey is their last chance.”

Moreover, Babacan will have to contend with opposition from within the AKP government. Erdo(breve)gan, who was stripped of his mayor’s office and imprisoned by the army in 1998 for reading a religious poem at a meeting, returned in triumph because his charismatic leadership attracted a wide range of followers. The party hierarchy drew together idealistic technocrats like Babacan and Prime Minister Abdullah Gül; veterans of Islamic politics like Abdulatif Sener, a former Finance minister who is now deputy premier for economic policy; and former Istanbul city officials like current Finance Minister Kemal Unakitan, a close ally of Erdo(breve)gan’s. Erdo(breve)gan himself wields authority without formal office, constrained, for the moment, by the military’s lifetime ban on his serving in Parliament. A compromise allowing him to serve as prime minister is expected sometime this year.

Ali Coskun, a deputy chairman of the defunct Islamic Virtue Party who’s now the AKP’s Industry and Trade minister, has been vocal in challenging the IMF-oriented technocrats. In December he promised state workers $6 billion out of the budget to repay “savings” that the government has been deducting from their paychecks since 1988. And he criticized as incompetent and pledged to revamp the Bank Regulation and Supervision Agency -- an independent board that the IMF credits with hauling Turkish finance out of the Dark Ages.

Prime Minister Gül slapped down both initiatives. Babacan blames miscommunication: “During the first few weeks of the government, all the ministers were very involved in their own ministry matters. We did not have cabinet meetings as often as we should.”

But spending measures that investors find disconcerting have become AKP policy -- forcing Babacan to fudge his surplus target. A pension increase announced at the start of the year will cost Turkey 1 percent of GDP, according to Credit Suisse First Boston. The government lifted the minimum wage 22 percent and announced construction of 15,000 kilometers of roads.

Although Gül has unveiled a tax and savings package intended to lift the surplus by 1.6 percent of GDP, Turkey will likely miss the IMF’s 6.5 percent bar. Current numbers “imply a need for further fiscal savings/tax measures of about 1.9 percent of GDP to satisfy the IMF,” writes CSFB analyst Berna Bayazitoglu.

The AKP has scratched an unpopular Dervi¸s plan to require Turkey’s legion of self-employed to account for their income and pay taxes. The government has also waffled on plans to cut corporate taxes and Turkey’s 18 percent value-added tax. And although the IMF wants a blueprint for privatizing Tekel before it releases the next loan tranche, it hasn’t gotten it yet.

Most disturbing of all to financial markets is the AKP’s plan to change the Public Procurement Law, which reformed state contracting procedures and was drawn up in consultation with the EU and World Bank. Coskun and Public Works Minister Zeki Ergezen tried and failed to postpone the law’s January effective date, and Erdo(breve)gan was promptly quoted in the press as advocating far-reaching amendments, such as exemption for municipalities from the law’s competitive tender requirements. The law’s prohibition on awarding contracts without funds committed in advance should also be scrapped, Erdo(breve)gan proposed.

Babacan says his boss just aims to make the act less unwieldy. “According to this law, it’s going to take four months to do any auction. What we are thinking about is implementability,” he says.

But investors and opposing lawmakers foresee a return to the days of useless projects built for political purposes. “Postponing or altering the Public Procurement Law contradicts what the AKP promised before the election,” says Mahmut Kaya, chief of research at Garanti Securities in Istanbul. “These contracts were a main source of corruption.”

Some builders agree. “Before, they might award a $100 million contract in one day, and it could be awarded to any Turkish citizen who bought a construction license from some retired official,” says Sezai Bacaksiz, vice chairman of Ankara-based Limak Construction, one of Turkey’s ten biggest contractors. “There were thousands of projects backed by some Parliament member or other going at the pace of a turtle because there was just a little money given each year.”

Then there are the great events that Turkey is all but powerless to affect. Opinion polls show that 85 percent of Turks oppose a U.S.-led war with Iraq. Islamic solidarity aside, Turkey probably suffered from the 1991 Gulf War more than any country except Iraq and Kuwait. The economy stagnated as Turkey lost trade and tourism, paid more for oil and saw a flight from its currency.

Babacan, whose duties include negotiating with the U.S. over assistance in the event of war, sees Uncle Sam mitigating the harm this time around. “We are making very clear to the U.S. government that the Turkish economy will be adversely affected,” he says, “and that Turkey has to be compensated for that.” Still, a few billion dollars from Washington won’t benefit the AKP electorate nearly as much as a repeat of the 6 to 7 percent growth Turkey achieved last year.

Yet for all the problems, it’s too soon to write off the AKP. Although Erdo(breve)gan may have thrown some sops to the party’s key constituencies, he is willing to candidly tell Turks that they face more sacrifices. The government hasn’t wavered in targeting surpluses to reduce debt. Agreement with the IMF on the next $1.6 billion loan tranche is expected soon, and Eurobond markets remain open to Turkey. Erdo(breve)gan and Gül, meanwhile, have quashed renegade AKP parliamentarians’ proposals to force the central bank to manage for growth rather than stability and to dilute the authority of the bank regulatory agency.

The beacon of EU membership has worked wonders on profligate economies from Ireland to Greece. It gleams too for Turkey. But Ali Babacan and his AKP will have to do better in their next four and three quarter years than they did in their first three months.

Why Turkey won’t go backward
Just two years ago Ali Babacan was helping his father run the family textiles business in Ankara. Today the former Fulbright scholar and Northwestern University MBA is Economy minister in the new government of Turkey’s fledgling Justice and Development Party (AKP).

Since the AKP’s election victory last November, Babacan has spent his days pitching U.K. Prime Minister Tony Blair on Turkey’s turnaround prospects, wrangling with the U.S. Treasury Department over the cost of Ankara’s cooperation on Iraq and fighting to squeeze Turkish inflation from 35 percent to 20 percent -- the government’s target for the end of 2003 (story).

Last month Babacan sat down with Institutional Investor Contributor Craig Mellow in Ankara for a wide-ranging interview.

Institutional Investor: You’ve said that the cornerstone of AKP economic policy is the drive for European Union membership. But the EU has not given Turkey all that you might have hoped. Has that discouraged you?

Babacan: What we got was not an exact date for starting accession talks but a conditional date. We are given until the end of 2004 to fulfill all the Copenhagen criteria [political requirements for EU membership]. What we were expecting was a little earlier date, but still I think this is a very concrete result. For at least the past 40 years or so, the idea of the EU was always a virtual thing for Turkey. But right now it’s real.

What is realistic to accomplish economically over the next 18 months or so?

There have been important reforms, and my government is working on further very important reforms. And the EU is, in a way, a guarantee that Turkey is not going to take any backward steps. It’s the basis for a more rational management of the economy.

Can you offer any concrete pledges?

For 2003 we have already declared that [retail] inflation is going to be 20 percent. For the year following, the official figure has not been announced yet. But we are expecting inflation in the 10 to 12 percent range for 2004.

In terms of debt-to-GNP ratio, the ultimate target is the Maastricht criterion [for EU membership], which is 60 percent. Turkey’s debt is on a decreasing trend. By having low interest rates and a reasonable amount of growth, and also by generating a substantial primary surplus, I believe we are going to bring down the ratio to 60 percent in three to four years.

So your reckoning of debt to GNP now is about 80 percent?

At the beginning of this year, it was more than 90 percent. That is public sector net debt stockto-GNP ratio. At the end of this year, we are expecting it to be about 80 percent.

And your main means of fighting inflation will be reducing debt?

Independence of the central bank is also a key step. The central bank right now takes price stability as its first priority. This approach is crucial. Also, having fiscal discipline. We are, as I said, generating a significant amount of primary surplus. It’s very, very crucial.

If there is war in Iraq, how do you expect that to affect the Turkish economy? What preparations are you making?

During the first Gulf War, in 1991, the Turkish economy suffered. But this time we have a much stronger infrastructure -- with the central bank’s independence, our floating-exchange-rate mechanisms and our policy of tightening fiscal balances. The effects of a [military] operation would be kept to a minimum level.

Plus, we are working closely with the U.S. Treasury about what kind of a support scheme the U.S. government could offer to Turkey. We made it clear that the Turkish government has not yet made any concrete decision on whether Turkey is going to be involved or not, and if it is involved, to what extent.

What we are making very clear to the U.S. government is that the Turkish economy, just because it is very, very close to the action, will be adversely affected, and Turkey has to be compensated for that.

During the last Gulf War, Turkey was hurt by a flight from the currency.

Turkey was affected on all fronts. In terms of GNP, the growth rate was expected to be roughly 5 percent for 1991. But it turned out to be 0.3 percent. Real interest rates were up about 10 percent or so. Tourism revenues dropped about 20 percent.

Does Turkey look to any other country, whether an EU member or an EU membership candidate, as a model for development?

We are observing closely what has happened in Spain, in Greece, in Portugal. We can see a huge flow of foreign direct investment into those countries. Their growth rate was tremendous after they became just candidates, not even members.

What I am working on personally right now, and spending most of my time on, is enhancing the investment environment in Turkey. We have already introduced five laws in Parliament. For example, we are changing the permission procedure for foreign investors. Under our new law there is no difference between a foreign investor and domestic investor. We are reducing the number of days to start a company to one day and making it easier for foreign employees to work in Turkey. Also, we are working on a tax-reform package, which has not been suggested to Parliament yet.

The AKP government seems at times to speak with different voices.

During the first few weeks of the government, all the ministers were very involved in their own ministry matters. We did not have cabinet meetings as often as we should. But then we increased the frequency of the cabinet meetings so that we could coordinate much better. I think we resolved that issue.

Some analysts talk about a so-called liberal wing in the government, including Prime Minister Abdullah Gül and yourself, as opposed to a more traditionally political wing involving Industry and Trade Minister Ali Coskun and some other people. Is there any truth to that?

The AK Party has a very wide spectrum of ideas, a very wide spectrum of people and almost a two-thirds majority in the Parliament. So it’s very natural that people might have slightly different tendencies and ideas toward different issues. But the more important thing here is that we have our election manifesto and we have our government program. These documents are binding documents. We have a certain set of policies to follow, and it is very clear where we are heading.

What’s happening with the Public Procurement Law (an act intended to reform lax state contracting procedures)?

The EU is also not 100 percent satisfied with the procurement law, which was drafted by the former government. So we are listening to the EU. We have formed a commission to correct the missing things, and our commission is going to prepare an amendment package to the law.

This is really an issue that goes to the heart of governance in Turkey.

Absolutely. The key is transparency and a truly competitive environment, but implementability is also very important. According to this law, it takes at least four months to [put out and accept bids]. The procedures and the time periods are so long, it’s very difficult for the government to take swift action in a lot of areas.

One of your colleagues said there would be very rapid progress on privatization, that all of the state properties left to be privatized will be put up for sale this year. Is that true?

Not all, but there is a list five pages long of the entities to be privatized this year. Mostly small entities but also some big ones.

The important thing here is the mentality, the approach and the political will to do the privatization. Some people say that the market conditions are not right. But we are not going to wait for one year or two years. Turkey has a large debt stock. We have to reduce this very fast, and privatization is one of the key strategies.

When do you expect agreement with the International Monetary Fund on the next tranche of its loan?

Fund officials are arriving toward the end of January, and they could work here maybe two weeks or so. We are working on the draft of a letter of intent. This is a new approach in Turkey. We are saying that this is our own economic program, and we own this program. It contains the main features of the IMF-supported programs, but it does much more. The people of Turkey should never see the economic program as a prescription.

Programs prescribed from the outside can never become successful. People should know that the economic program is a program of our government.

So far discussions with the IMF are going well. We agree on the diagnosis of the problems in Turkey; we agree on the policies of how to resolve them. The discussions we have are usually about the timing of the reforms or some certain percentages -- those kinds of technical issues, not policy issues. On the general framework of policy, we have no problems.